Finance Market Update – 29 March 19
Did the RBA admit to causing the housing boom? Well they at least calculated they sparked it off. We discuss this and how they are trying to influence your thoughts in this update.
Talking points in this update
1. The psychology of cash rate cuts
The RBA is trying to get inside your head. When they drop the cash rate they want to see you borrow and spend more. They are trying to make you think now is a good time to spend. But would it really change how you spend? I think not, you can read my thinking in this update.
2. If interest rates were the spark, credit was the fuel to the fire
What do you blame for a house fire? Is it what caused the spark, what the house was made of, or that the fire fighters didn’t get there in time? We will see a blame game start when things go bad, a nationwide house fire if you will, so who is to blame? Read below…
The RBA is trying to change your mind
When the RBA drops the cash rate what they are trying to do is to get you to borrow and spend more.
In economic terms, this is referred to as monetary policy. But it is also a bit of a psychological tactic by making money cheaper, which the theory goes means you are more likely to go and buy something.
The more people buy the more economic activity there is which roughly translates into a growing economy, which is what the government wants, more activity means more taxes. Or at least a growing economy within their 2-3% inflation target band, meaning they want the economy to grow between 2-3% a year.
Anymore than that rate is considered ‘bad’ inflation and would be the time the RBA increases rates, making money more expensive which will hopefully mean you borrow and spend less, which should slow down economic activity and growth. Deflating the economy.
The opposite also holds true, when the RBA drops the cash rate, they are trying to boost economic activity, this is what they are considering right now, whether they should try and make you borrow or spend more. And Because one person’s spending is another person’s income, whether that spending is borrowed money (credit) or cash, does not make a difference to the government because they tax it just the same and it is all welcome economic activity.
Here is a question for you - would you go out and buy that new car or tv if the cash rate dropped?
I would guess not. Most likely because you have already bought it when property prices were rising over the past few years which made you feel rich (aka the wealth affect), or you are worried about property prices falling now and all the uncertainty going on which makes you want to save.
A leading economic indicator of consumer spending and general confidence is the number of new car sales, this is looked at because often people will buy a new car when they feel rich. Over the past 3 years the peak of new car sales was in the middle of 2018, quite coincidentally around when the big drops in property prices were being reported.
If the cash rate is cut, and if the big banks pass on that cut to borrowers, (which is a big ‘if’) the thinking goes that you will borrow or spend more. But in reality, this probably won’t happen, in all likelihood for the average mortgage holder it won’t make a huge difference.
Let’s look at an example.
If the RBA dropped the cash rate by 50 basis points my estimate is that the big banks will pass on about 30 points to their customers.
The ‘advertised’ average standard variable cash rate from the big four banks sits around ~4.8% (which by the way is ridiculously high and if your mortgage doesn’t start with a 3 we should talk) so if that reduces to 4.5% based on an average loan size of $500,000 over 30 years your annual reduction in repayments would be $1,080.
Would a thousand dollars make you feel rich enough to go out and buy a new car? Again, my guess is that it would not.
Though if it does, and you want a car loan, we can arrange that 😉
More than likely you would put that extra cash into your offset account or paydown your debts, because on average Australian household indebtedness is huge, sitting at nearly at 200% of household income. This means that on average for every pre-tax dollar you earn you owe $2. And it is a good idea in a market with falling values to pay down debt or build your cash up.
Getting you to borrow and spend more is what the RBA is trying to do when they drop the cash rate, it is a bit of a mind game they are playing. That does not mean there is no real benefit in a rate cut, a thousand dollars could really help peoples cashflow, but it might not be enough to get people to spend go out and spend a lot when they already have huge mortgages and other debts.
Let the blame game begin
Should we blame the RBA for falling property prices?
Last week two economists from the RBA released a paper that concluded “reduction in real interest rates [effected by the RBA] accounts for most of the subsequent boom in dwelling prices” during the 2012 – 2017 period when house prices effectively doubled.
This is a staggering claim.
Not only because it comes from people within the central bank but because they are saying it was the RBA cutting interest rates to historical low levels is what flowed through to cause house prices to double over the past boom.
They are essentially saying that the low cash rate was the spark that lead started the fire, the fire of course being the housing boom.
I have written consistently about how credit drives property prices since August 2018 and talk about this with almost everyone I discuss business with. This paper in essence is backing this line of thinking because it is saying that as rates were lowered people borrowed more, as people borrowed more house prices increased.
Low rates = more borrowing of credit = higher property prices.
So, as we are seeing a massive house price correction now of ~10% so far, and could be as bad as 20% peak to bottom, who should we blame?
The RBA for lowering rates, banks for pumping debt out or ourselves for taking the loans?
The RBA hasn’t changed the cash rate for two and a half years, but banks have been moving their rates up and down during that time, which as I have said before means the banks are partly doing the RBA’s job for them.
If the cash rate was the spark, credit was the fuel for the housing boom fire.
There were a few things that the banks did which lead to massive lending and the boom. They had relaxed lending policies which used misrepresentative benchmarks (HEM) on living expenses which lead to people being able to borrow more than they should. And gave out hundreds of thousands in ‘interest only’ loans to investors, who as prices are falling are seeing ‘negative equity’ or being forced to sell at a loss or facing declining yields. All of this lending was the fuel for the fire.